Reverse Auctions Reveal Purchasing Pitfalls
Reverse Auctions: Years after the purchasing phenomenon swept through the pallet industry, lessons can be learned from the failures of reverse auctions.
By Chaille Brindley
Date Posted: 7/1/2006
More than ten years after reverse auctions developed into a major purchasing fad, the process is still around although the hype has worn off as real world numbers have raised practical issues. While the concept did save money for some companies, it caused headaches and unmet expectations for many others. Looking back on the phenomenon that rocked many industries, including the pallet market, the history of reverse auctions reveals many of the pitfalls in modern purchasing strategies as well as the decision making traps that snag many executives.
FreeMarkets Online, Inc. first introduced the reverse auction concept in 1995. The first supplier to try using reverse auctions for purchasing pallets was Quaker Oats in August 1999. Then, the pallet industry became wrapped up in the reverse auction phenomenon as large multinational corporations looked to cut costs.
Reverse auction service providers, commonly called market makers, arrange for suppliers to compete in real time for a client’s business using a private computer network or over the Internet. The auction format is called “reverse” because unit prices lower over time rather than increase.
Reverse auctions have been used for everything from fairly simple products, such as tissue paper and pallets, all the way to more complex items, such as aerospace machine parts. There are mixed results as to where reverse auctions work well. Seemingly simple items tend to be frequent targets for market makers. But these products can be much tougher than imagined to source using reverse auctions. Vendor failure can result in poor product quality, missed deadlines, limited supply, or any number of things.
One of the early problems for reverse auctions was that market makers did not effectively screen participants. While there may be some that have fixed the problem, Dr. Bob Emiliani, an expert on reverse auctions, said that overall he still hears a lot of feedback from buyers that there tend to be suppliers involved in the auctions that are not qualified to bid. Bob is a professor at Central Connecticut State University who specializes in lean business management. He used to work as a procurement manager for Pratt & Whitney where he even participated in some early reverse auctions.
Some reverse auction cheerleaders have criticized Bob’s work. But he claims that he has no vested interest in the debate because he has never acted as a consultant or sold his reverse auction research or expertise.
After the initial hype about reverse auctions a number of years ago, the industry went through a massive consolidation. Some of the big names in the initial phase were bought up or went out of business. Many companies jumped on the reverse auction service bandwagon hoping to claim a piece of the action.
Bob said, “These days Ariba, Perfect Commerce, A.T. Kearney and VerticalNet are some of the major players. There still are many smaller providers out there. It is kind of surprising to see the resurgence of the small players that have entered this market space.”
The government is still a major user of reverse auctions. Agencies are attracted to the promise of lower initial unit purchase price compared to total system cost.
Pallet companies have reported that reverse auctions were used primarily
Bob said, “Less than 50% of the work actually ends up at a different supplier. Some of the data is proprietary with the market makers and the buyers. But the public data that I have seen is on the order of 25% or so, maybe as high as 50% in some cases ends up being moved to a different supplier.”
According to Bob, the cost of switching suppliers was initially just an estimate that was determined by the buyer not grounded in much reality. Bob said, “It was typically 10% lower than you are currently paying for something is the price below which it would be worth it to switch sources. In fact the difficulties and costs associated with switching suppliers appear to have had a negative impact on the spread of reverse auctions. Switching turns out to be more difficult and costly than people imagine even sometimes for relatively simple items. Overall, the cost of switching suppliers has not been factored into the equation well, which is kind of surprising because these reverse auctions have been around for ten years and they are still struggling with basic issues, such as switching costs.”
Reverse auctions have also struggled because there tends to be no value proposition for the suppliers. Market makers and customers have to pressure suppliers to participate. Getting companies involved is the key to make reverse auctions work.
Bob said, “The reverse auction process, you make it or break it based on whether or not you have bidders. There is tremendous pressure to get bidders…In some cases, companies are desperate to get bidders in order to run the reverse auction on schedule.”
This can lead companies to accept warm bodies just to meet the required numbers. There may not be proper screening or qualification to ensure that those who bid can actually deliver on the business.
Some critics contend that reverse auctions actually create false markets where people bid irresponsibly or some vendors bid even though they cannot effectively service the customer. “Sellers do often bid irresponsibly, especially if it’s their first time. They get caught up in the reverse auction process,” said Bob.
Allowing brokers to participate has been a contentious issue at times because it may be easier for them to bid low prices and just walk away if the bid price drops below a realistic price point. And if the whole concept is to get the lowest price, then some contend that brokers just add cost to the system. It can be cheaper to cut out any middle men. Of course, this strategy comes with problems too because brokers can provide a valuable service.
Reverse auctions appear to be decreasing. Companies at first wanted
Over the years, Bob has conducted research with a number of industries, including pallets. His research in the pallet industry and its results were strikingly similar to what he discovered in other industries. From aerospace machine parts to packaging, and pallets, there was very little difference because many of the issues come down to human nature.
In most cases, Bob reported that reverse auctions simply reduced price by the supplier giving up margin and not through fundamental cost reduction at the source of the cost in the supplier’s operation. Suppliers have to produce at lower prices. There is a tendency to skimp on some things. You end up finding that a lot of these items don’t meet the specifications. The buyer ends up going back to the original supplier at the old price or even a slightly higher price in some cases. A number of leading pallet companies reported finding that exact scenario played out in their businesses.
No matter the hype or what the auction says when it ends, the real cost savings is determined by the implementation stage of the procurement process. Bob’s research indicates that at least 50% of the supposed savings for reverse auctions disappears upon implementation.
And there were some other unforeseen results, too. Customer retaliation was one of the more surprising aspects of aftermath from reverse auctions. Buyer gets in a jam. Then a supplier charges expedite, tooling or service fees to makeup lost margins. Bob found a strong propensity to retaliate in the aerospace industry. But this attitude was not as common in his research of the pallet industry.
Even though reverse auctions don’t work very well, the market makers keep pushing the concept. Bob said, “I think that one of the reasons why reverse auctions continue to go forward is the metric that buying organizations use to determine savings. They use the purchase price variance metric, which turns out to be something easily gained and give the appearance that savings are achieved.”
Executives went nuts over the reverse auction concept. In the pursuit of quick price reduction, they fell into a number of management decision traps. These traps are described in greater detail in the sidebar to the the left.
Bob summed up his opinion of reverse auctions, “Through our own experience running reverse auctions, we found there to be a lot of hype surrounding it. These reverse auctions were not easy to do. The savings were not really quick and measurable as claimed by the auction makers. In fact, the savings were fairly elusive.”
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